Hypothecation

Corbin Securities sends a new margin customer, Wren Delacroix, the firm's margin agreement package before her first trade. Which component of that package is OPTIONAL for Wren to sign?

1. A.The hypothecation agreementHypothecation pledges the customer's securities as collateral for the debit balance. A margin account cannot function without it.
2. B.The credit agreementThe credit agreement states the interest terms and conditions of the loan. Without it there is no basis for extending margin credit, so it must be signed.
3. C.The loan consent agreementCorrect. Loan consent permits the firm to lend out the customer's securities and is the one piece the customer may decline.
4. D.The customer's account applicationThe account application supplies the identifying and suitability information every account requires. It is not part of the margin package and is never optional.

Why: The margin agreement has three parts. The credit agreement sets out the terms and interest on the money loaned, and the hypothecation agreement pledges the customer's securities as collateral; both are required. The loan consent agreement, which permits the firm to lend the customer's margin securities out to others for short sales, is optional and the customer may decline it without losing margin privileges.

Cordelia already has a cash account at Bramwell Securities and now wants the ability to borrow against her holdings. The firm sends her a margin package containing a credit agreement, a hypothecation agreement and a loan consent agreement. Which statement is CORRECT?

1. A.All three documents must be signed before the margin account may be opened.The loan consent agreement is optional; the account may be opened without it.
2. B.The credit and hypothecation agreements are required, while the loan consent agreement is optional.Correct. Credit and hypothecation are required to establish and secure the loan; consenting to have securities lent out is voluntary.
3. C.Only the credit agreement is required, because the securities in the account are automatically pledged by operation of law.Securities are not pledged automatically. The hypothecation agreement is what creates the pledge.
4. D.The hypothecation and loan consent agreements are required, while the credit agreement is optional.This reverses the position. Loan consent is the optional document and the credit agreement is required.

Why: The credit agreement sets out the terms of the loan, including interest, and the hypothecation agreement pledges the customer's securities as collateral for that loan; both are required to open and operate a margin account. The loan consent agreement, which permits the firm to lend the customer's margin securities to others, is optional, and the customer may open the account without signing it.

A grandparent wants to open a custodial account for a minor and asks whether the account can be set up as a margin account so the minor's investments can be leveraged. What should the firm tell the grandparent?

1. A.Yes, as long as the custodian signs the margin agreement personally and accepts liability for the debit balance.Wrong. A personal guarantee from the custodian does not cure the underlying problem that the custodian cannot pledge the minor's assets.
2. B.No -- a custodial account cannot be a margin account, because the custodian has no authority to pledge the minor's assets as collateral for a loan.Correct. The custodian lacks authority to pledge the minor's assets, which a margin account requires.
3. C.Yes, but only up to the amount of the minor's own earned income contributed to the account.Wrong. The source of the funds contributed does not grant the custodian authority to pledge the assets as loan collateral.
4. D.No, but only because custodial accounts are limited to a single security type, which makes margin trading impractical rather than prohibited.Wrong. The prohibition is not about security type limitations; it is the custodian's lack of authority to pledge the minor's assets.

Why: A custodian who opens and manages an account for a minor has authority to invest the minor's assets, but that authority does not extend to pledging those assets as collateral for a loan, which is exactly what a margin account requires. Because the custodian cannot lawfully grant the hypothecation the margin agreement depends on, a custodial account for a minor cannot be structured as a margin account at all, regardless of the custodian's own financial standing or willingness to accept liability.

Ardmore Securities holds fully paid common stock belonging to cash account customers. Under the SEC's customer protection rule, what must the firm do with those securities?

1. A.Pledge them to a bank as collateral for the firm's own borrowingOnly margin securities may be repledged, and even then only up to a percentage of the customer's debit balance. Fully paid securities may not be pledged at all.
2. B.Maintain possession or control of them at a good control location, free of lienThis is the core requirement of the customer protection rule for fully paid and excess margin securities.
3. C.Lend them to short sellers, provided the proceeds are credited to the firm's reserve accountLending fully paid customer securities requires a separate written agreement with the customer; it is not authorized by depositing proceeds anywhere.
4. D.Transfer them into street name so they can be included in the firm's net capital computationCustomer property is never an asset of the firm, and street name registration does not convert it into one.

Why: Rule 15c3-3 requires a broker-dealer to promptly obtain and thereafter maintain physical possession or control of all fully paid and excess margin securities carried for customers. Control means holding them at a good control location such as a clearing agency or a qualified bank, free of any lien or claim. These securities are the customers' property and may not be pledged or lent to finance the firm's business.